Tuesday, October 30, 2007

Great Moderation Watch, again; liquidity @ Financial Times; bearish Bill Gross; Bill Luby and a new era for the VIX; the Financial Ninja & the mysterious spike in the Fed funds rate.

[1] Great Moderation Watch: the IMF. I don't know what to make of this, but the fact is, everybody is talking about the "Great Moderation" of the business cycle and related ideas ("great divergence", "global decoupling", etc). Readers of this blog will recall that, IMHO, the "Great Moderation" is a key component of market liquidity. In chapter 5 of the World Economic Outlook, IMF ecomomists ask themselves: 'What is Driving the Moderation of the Global Business Cycle?' They single out three key variables: (a) Institutional quality; (b) Macroeconomic policies; (c) Financial deepening. (They discard, rather surprisingly, the role played by inventory management techniques). They conclude with guarded optimism: "... the increased stability of economies and the associated increase in the durability of expansions largely reflect sources that arelikelyto prove persistent ... Overconfidence in the ability of the current policy framework to deliver stability indefinitely would certainly not be warranted. Although the business cycle has changed for the better, policymakers must remember that it has not disappeared". [IMF: "The Changing Dynamics of the Global Business Cycle", World Economic Outlook].

[2] Great Moderation Watch: Liquidity @ Financial Times. The FT's Andrew Wood interviews a number of economists about the "great divergence" and the associated issue of "global decoupling". According to Geoff Lewis at JF Asset Management in Hong Kong, "decoupling is a fact", and it is largely due to the 'domestic nature' of Asian economic growth. Mr. Lewis feels confident enough to shrugg off 'the view that any credit squeeze-induced slowdown in the US would affect Asia'. But decoupling has many doubters, as Andrew Wood points out. He cites Markus Rosgen (Citigroup) and Bryan Olson (Charles Schwab) as chief sceptics. Monetary and exchange rate policies are not decoupled, they argue. My own two cents: in the short term, decoupling is a fact, and it will help the "Great Moderation" cause. But I worry about ... the medium term. [Andrew Wood: "Why the talk about a great divergence could be premature", Financial Times].

[3] Great Moderation Watch: Morgan Stanley. Richard Berner analyzes inventory to sales ratios, both in nominal and real terms, and concludes that 'the downside risks from the inventory accelerator are limited'. Indeed, he adds, 'the offshoring of production has a silver lining: It shifts the inventory cycle to overseas locations and reduces the cyclicality of US output'. [Richard Berner: "Inventories: A Recession Trigger?", Morgan Stanley GEF]. Berner's collegue Stephen Jen reviews the definition of Sovereign Wealth Funds and argues that 'SWFs already played a meaningful role in September, facilitating the recovery in EM equities and equities in general. Having such a different ‘temperament’ from private funds, SWFs should reduce the risk of ‘herd behaviour’ ... Furthermore, market efficiency is a function of market liquidity. To the extent that SWFs improve market liquidity, particularly in a way that is not ‘herdish’ like other types of short-term capital flows, SWFs should be a positive factor for markets in general". In other words, SWFs are seen as a source of stability, and as such they contribute to market liquidity. [Stephen Jen: "The Definition of a Sovereign Wealth Fund", Morgan Stanley GEF].

[4] Bearish Bill Gross. The very bearish PIMCO manager sees more pain ahead — much more: "An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s". [Bill Gross: "Shadow Dancing". PIMCO Bonds].

[5] Bill Luby & the VIX. Because the VIX plays a non-trivial role in my Endogenous Liquidity Index, I always pay attention to what Bill Luby has to say. Well, Bill is a cautious bull — on the VIX, that is (I guess I could call him an "endogenous liquidity bear"). According to Bill, a 15 VIX increasingly looks like a long-term bottom. [Bill Luby: "Volatility in a 130/30 Era", VIX and More].

[6] A mysterious spike in the Fed funds rate? Ben Bittrolffhas detected an "ominous spike in the Fed Funds rate on 10/25/07 to 15%. The data is here". Any ideas? ["WTF Happened to the Fed Funds Rate?", The Financial Ninja].

[7] Bearish David Malpass. The Bear Stearns chief international economist, a keen watcher of liquidity trends, sounds very bearish. [HT: Rich Karlgaard & his excellent blog]. "We expect", writes Malpass, "a credit-driven economic slowdown beginning in the fourth quarter due to the August changes in credit markets. We think the U.S. slowdown and global credit market disruptions will pressure earnings, equity prices, commodities and foreign growth more than is reflected in the current consensus ... We expect inflation to be problematic in coming months as prices make up for dollar weakness. We think the Fed underestimates this linkage". [Rich Karlgaard: "Third Quarter Strength, Stagflation Ahead", Digital Rules].

If I understand Stephen Jen correctly, what he has in mind is the following: SWFs provide a "counterweight" to more traditional forms of finance. To the extent that their activity helps to soften the business cycle, they are in effect contributing to market liquidity. Interesting -- although perhaps too optimistic.